Small, development stage biotech companies are widely considered to be attractive targets for securities actions given the inherent risks of the industry and the volatility of their stock prices. As a result, many of these companies have relatively limited D&O insurance options. But are the assumptions that act to limit their options correct? Do biotech startups actually pose greater securities class action risk than other companies?

As described below, we surveyed all biotech securities class actions in the past decade to better understand how they have fared in the federal courts, and found that they were actually more likely than other types of cases to be dismissed early in the litigation, saving defendants (and insurers) from the bulk of potential legal costs. This turns the conventional wisdom on its head and suggests a number of important insights that can help biotech companies avoid and successfully defend against securities suits, and help insurers make better coverage decisions regarding these companies.

In short, biotech cases are manageable risks if they are defended correctly, especially if biotech management takes proactive steps to manage its disclosures in a way that will further limit its risks. Below, we describe the study we undertook and its results, in light of which we then identify four of the biggest myths surrounding biotech securities cases and explain why each is unfounded. Finally, we describe and analyze the real driving forces behind these decisions, and we explain how biotech companies, their attorneys, and insurers can use these insights to greatest advantage.

II. Study Methodology and Results

We searched for and reviewed all of the district court decisions on motions to dismiss biotech securities cases within the past eleven years in order to identify the subset of cases that concern development-stage biotech companies’ efforts to bring their first drug or device to market.[i] Only decisions that met all of the following criteria were included in our study set: final district court decisions[ii] on motions to dismiss federal securities claims where the biotech company did not already have a drug or device on the market and its alleged false or misleading statements concerned clinical trials or the FDA approval process for its primary drug or device candidate.[iii]

Of the 61 decisions in our study set that met these criteria, 69% resulted in complete dismissals. Moreover, the dismissal rate appears to have increased in recent years: 78% of the decisions in the study set from 2012-2016 resulted in complete dismissals, compared with only 56% of decisions from 2005-2011. Interestingly, this shift seems to have occurred even as more securities class actions were being filed against small biotech companies: 36 decisions in the study set came from the most recent five years, versus only 25 decisions from the previous seven years. Contrary to conventional wisdom, this analysis indicates that federal securities claims brought against biotech companies regarding the regulatory approval process actually are dismissed more frequently than average at an early stage in the litigation.[iv]

III. Four Myths about Biotech Securities Cases

These findings overturn several important assumptions that currently guide biotech management and are baked into the insurance market for young biotech companies:

Myth #1: Cases against biotech companies for failed clinical trials or products that are not approved by the FDA are risky and expensive.

FACT: Our analysis shows that about two-thirds of these cases are dismissed in full, and with self-insured retentions that average a million dollars or more most such cases will not even exhaust the company’s retention. A well-managed motion to dismiss process for a young biotech should cost no more than $500,000 – $750,000, and often far less, and is highly likely to result in a favorable early outcome for defendants in these actions.

Myth #2: Management puts the company at risk if it speaks too positively regarding its expectations of clinical trial results, FDA approval, or product commercialization.

FACT: As discussed in more detail below, statements of opinion will be protected under Omnicare,[v] so long as they are genuinely held and not misleading when considered in their full context. Optimistic forward-looking statements will also generally be protected by the Private Securities Litigation Reform Act’s (“Reform Act”) safe harbor for forward-looking statements, provided they are accompanied by sufficiently specific cautionary language.[vi] Courts recognize the inherent uncertainty in the FDA approval process and understand that predictions sometimes will prove wrong; the important thing is for companies to make a meaningful effort to help investors understand these risks. Effective legal counsel can help companies manage their disclosures in a way that allows for optimistic statements while protecting against future litigation.

Myth #3: Once negative results become public, any positive spin given by management will be viewed as misleading.

FACT: Even in the face of bad news, positive statements of opinion will not be viewed as false or misleading if they are honestly held and are made within the proper context, especially where the company accurately discloses the underlying facts. Courts do not require companies to be pessimistic in assessing arguably negative results; they merely require that companies be honest in their statements and forthcoming with the relevant underlying facts. See, e.g., Sarafin v. BioMimetic Therapeutics, Inc., 2013 WL 139521, at *13-14 (M.D. Tenn. Jan. 10, 2013) (dismissing where defendant characterized clinical trial results positively even though FDA had expressed concerns and contemporaneous news reports described the results as disappointing).

Myth #4: Cases will not get dismissed if the company raises capital or insiders sell stock during the class period.

FACT: These facts may contribute to an inference of scienter in some circumstances, but they are not determinative. Far more important is the overall story, and whether the alleged motivation to commit fraud makes sense in the context of this larger narrative. When courts are convinced that the defendants were trying their best for the company and were honest and forthright in their public statements, they tend not to be concerned about capital raising or insider sales during the class period. See, e.g., Brennan v. Zafgen, Inc., 2016 WL 4203413, at *2 (D. Mass. Aug. 9, 2016) (“[T]he complaint’s circumstantial allegations concerning scienter—a patchwork of scientific literature and unsuspicious insider sales—are insufficient to support a strong inference of defendants’ conscious intent to defraud or high degree of recklessness.” (internal quotation marks omitted)); In re MELA Sciences, Inc. Sec. Lit., 2012 WL 4466604, at *5 (S.D.N.Y. Sep. 19, 2012) (“To the extent the [proposed amended complaint] relies on MELA’s capital raised during the Class Period, the court finds this inadequate to support an allegation of intent to commit fraud.”). But see Gargiulo v. Isolagen, Inc., 527 F. Supp. 2d 384, 390 (E.D. Pa. 2007) (scienter was sufficiently pleaded based on several factors, including that defendants allegedly sold their respective securities at the time for “considerable gain”).

IV. Case Trends and Practice Tips

Careful review of the decisions in the study set not only upends the myths described above, but also reveals important insights into how courts actually decide these cases and what companies and legal counsel can do to head off and defend against these suits.

A. Decisions are often driven by the court’s overall feeling about whether or not the company was being forthright and dealing honestly.

District court judges, like anyone else, are influenced by their overall impressions of the parties and the facts, even at the earliest stages in litigation. Motions to dismiss frequently turn on how the court chooses to characterize the pleadings, which leaves significant room for outcome-driven analysis. This may seem obvious, but has important practice implications, as discussed below.

Decisions in our study set—both those that dismissed and those that did not—showed again and again that in applying the pleading standard and securities laws to young biotech companies, judges appeared to be swayed by their overall sense of whether or not company management had honestly been doing its best to bring a product to market and inform investors of significant developments in a timely manner. Where courts saw little indication of good faith, they rarely dismissed. As one court put it:

“[N]otwithstanding the defendants’ contentions to the contrary, their allegedly misleading statements bear no hallmarks of good faith error. The defendants are sophisticated scientists running a regulated, publicly traded corporation; they are alleged to have misrepresented their regulator’s feedback, misrepresented the legal context in which they operated, heralded scientific results which they knew to be the product of empirically faulty procedures and manipulated statistical analysis, and claimed a level of external review that simply did not exist. If the defendants have good faith explanations for these misstatements…they do not emerge from the complaint.”

But when defendants presented a credible narrative evidencing good-faith, courts seemed inclined to run with it, absent specific, compelling allegations to the contrary. SeeIn re Axonyx Sec. Lit., 2009 WL 812244, at *3 (S.D.N.Y. Mar. 27, 2009) (dismissing and noting that “[t]he idea that this company, highly dependent on the success of the new drug, would knowingly or recklessly carry on a defective trial—so that any defects were not remedied—virtually defies reason, unless the company was bent on defrauding the FDA and the suffering people who might use the drug. Nothing of that sort is even suggested in the complaint.”); see also, e.g., Kovtun v. VIVUS, Inc., 2012 WL 4477647, at *3, 10 (N.D. Cal. Sep. 27, 2012) (dismissal appears partly influenced by fact that drug was ultimately approved after the class period, making alleged intentional misrepresentations re approvability improbable).

This seeming inclination to dismiss when presented with a convincing defense narrative appears to reflect two underlying beliefs that favor biotech defendants and may help drive the high dismissal rate in these cases: (1) that the research and development of new drugs and medical devices constitutes an important public good, and (2) that investment in development-stage companies, which have no existing revenue stream, is inherently particularly risky. As courts explicitly have noted:

“There is a significant public interest in the development of life-saving drugs. For every drug that succeeds, others do not. Clinical trials are phased into stages: some drugs never make it past the first stage, others never make it past the second stage, and so on. The costs of failure are high, but the rewards for success are also high. The relationship and ratio between the two determines whether, as a matter of economics, the costs of experimentation are worth it. Publicly traded pharmaceutical companies have the same obligations as other publicly traded companies to comply with the securities laws, but they take on no special obligations by virtue of their commercial sector. It would indeed be unjust—and could lead to unfortunate consequences beyond a single lawsuit—if the securities laws become a tool to second guess how clinical trials are designed and managed. The law prevents such a result; the Court applies that law here, and thus dismisses these actions.” In re Keryx Biopharmas., Inc., Sec. Lit., 2014 WL 585658, at *1 (S.D.N.Y. 2014).

“[I]nvesting in a start-up pharmaceutical company like Adolor involves a certain amount of risk on the part of investors. No matter how safe that risk may seem at the time, there are no guarantees, and Defendants never suggested otherwise. The fact that Plaintiffs now suffer from buyer’s remorse does not entitle them to relief under Rule 10b-5.” In re Adolor Corp. Sec. Lit., 616 F. Supp. 2d 551, 570 (E.D. Pa. 2009).

Against this backdrop, biotech defendants are well-positioned to secure early dismissals if they simply tell their stories and frame the facts in a manner that demonstrates their good faith. On the front end, this means companies will benefit from getting legal counseling on their disclosures, so that if trouble arises the disclosures will show a pattern of being honest and forthright and avoid indications of fraud in the context of the company’s particular situation (i.e., the state of its communications with the FDA, financing, stock sales, etc.).

Once biotech defendants have been sued, however, they should focus on selecting counsel who will tell their overall story in a way that emphasizes their honestly and does not just focus on a technical defense. Too many defense attorneys feel constrained to make narrow, technical arguments at the motion to dismiss stage—when plaintiff’s factual pleadings are to be taken as true—rather than mounting a normative defense of their clients’ conduct. As the decisions (and results) in our study set show, this is a missed opportunity. The decision in Omnicare expressly allows and even encourages defendants to tell their versions of the story by declaring that whether a statement of opinion (or, by clear implication, a statement of fact) was misleading “always depends on context.” 135 S. Ct. at 1330. Under this standard, courts are required to consider not only the challenged statements and the immediate contexts in which they were made, but also other statements made by the company and other publicly available information, including the customs and practices of the industry.

Evaluating challenged statements in this broader context nearly always benefits defendants, since it helps courts better understand the statements and makes them seem fairer than they might on their own. Moreover, in combination with the Supreme Court’s directive in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to assess scienter based on not only the complaint’s allegations but also documents on which it relies or that are subject to judicial notice, Omnicare now clearly requires courts to consider a broad set of probative facts each time they decide a motion to dismiss federal securities claims. Effective defense counsel will take advantage of this mandate and continue to use the motion to dismiss to tell their client’s story in a way that frames the facts and issues favorably and helps the court feel comfortable dismissing the suit.

B. Statements of opinion and forward-looking statements are generally safe, even more so after Omnicare.

The sorts of forward-looking statements of opinion that biotech companies often most want to make about their flagship products are not actually likely to get them into trouble, so long as the statements are honestly believed and are accompanied by disclosures that acknowledge specific, relevant uncertainties.

1. Claims challenging statements of opinion—including optimistic predictions—are likely to be dismissed under the Omnicare

Even before the Supreme Court’s recent decision in Omnicare, courts tended to find statements of opinion to be non-actionable on a variety of different theories (e.g., puffery, lack of falseness, immateriality, etc.). After all, “[p]unishing a corporation and its officers for expressing incorrect opinions does not comport with Rule 10b-5’s goals.” In re Vical Inc. Secs. Lit., 2015 WL 1013827, at *8 (S.D. Cal. Mar. 9, 2015). So, for example, the court in Shah v. GenVec, Inc., 2013 WL 5348133 (D. Md. Sep. 20, 2013), found the defendants’ positive characterizations of interim data to be immaterial “puffery” and, therefore, non-actionable:

“Plaintiffs properly characterize their challenge as Defendants placing ‘an unjustifiably positive spin on the data available at the time of the [first interim analysis] by using terms like “encouraging” and “bullish[.]”’ Such vague and general statements of optimism constitute no more than puffery and are understood by reasonable investors as such. Accordingly, they are immaterial and not actionable under § 10(b).”

The decision in Omnicare, however, as discussed above, established a clear, unified, and even more defendant-friendly standard for assessing statements of opinion in securities cases: an opinion is only false if the speaker does not believe it, and it is only misleading if it omits facts that make it misleading when viewed in its full, broadly understood context. See id. at 1328-30. Thus, a company’s statements of opinion—including optimistic projections about clinical results or FDA approval—are not actionable as long as the company actually believed them at the time and they were not misleading in their full context. For example, applying this standard in Gillis v. QRX Pharma Ltd., 2016 WL 3685095 (S.D.N.Y. July 6, 2016), the court concluded that the defendants’ optimistic statements that it was “encouraged” by FDA feedback and was “confident that [its drug candidate would] receive approval” were opinions, and plaintiffs had failed sufficiently to allege that defendants did not believe them or that they were misleading in context. Id. at *21-23. See also, e.g., Corban v. Sarepta, 2015 WL 1505693, at *8 (D. Mass. Sep. 30, 2015) (“[T]he company’s statements that it was encouraged by the feedback and believed its data would be sufficient for a filing constituted an expression of opinion,” which the court found not to be actionable).

Both the district court (before Omnicare) and the Second Circuit (after Omnicare) came to the same conclusion regarding the optimistic predictions at issue in In re Sanofi Securities Litigation.[vii] There, plaintiffs alleged that the defendants’ optimistic statements concerning a drug candidate’s likelihood of approval and its clinical results were misleading where they failed to disclose that the FDA repeatedly had expressed concerns about the company’s use of single-blind studies. In re Sanofi Sec. Litig., 87 F. Supp. 3d 510, 517 (S.D.N.Y. 2015). Applying the Second Circuit’s pre-Omnicare standard, the district court concluded that the challenged statements all were statements of opinion, and dismissed because plaintiffs had not established either that the opinions were not honestly held or that they were “objectively false.” Id. at 531-33. The Second Circuit affirmed, but took the opportunity to apply the Supreme Court’s then-recent Omnicare standard to the facts at hand, emphasizing in particular the larger context in which the challenged statements were made:

“Plaintiffs are sophisticated investors, no doubt aware that projections provided by issuers are synthesized from a wide variety of information, and that some of the underlying facts may be in tension with the ultimate projection set forth by the issuer. . . . These sophisticated investors, well accustomed to the “customs and practices of the relevant industry,” would fully expect that Defendants and the FDA were engaged in a dialogue, as they were here, about the sufficiency of various aspects of the clinical trials and that inherent in the nature of a dialogue are differing views.”

Of course, even statements of opinion can be false if they’re not genuinely believed; making an optimistic projection about FDA approval when a company has specific reason to believe the drug will not in fact be approved is likely to get it into trouble. So, for example, in In re Pozen Sec. Lit., 386 F. Supp. 2d 641 (M.D. N. Car. 2005), the court refused to dismiss claims regarding optimistic statements by the defendant touting its drug candidates’ effectiveness and implying their approvability, where the company knew at the time that it was applying a statistical analysis different from what it had agreed to with the FDA and knew that the drugs had failed in part to meet a critical clinical measure it had specifically agreed upon with the FDA ahead of time. Id. at 646-47. The court noted that the defendants might well have had other reasons to believe their own expressions of optimism at the time—which would make these statements of opinion not false—but it found the allegations sufficient to survive a motion to dismiss. Id.

2. Predictions of clinical trial success or FDA approval usually are also protected forward-looking statements

Not only are most optimistic projections statements of opinion, subject to Omnicare’s rigorous standard, they also tend to be forward-looking statements protected under the Reform Act’s safe harbor.

Courts in the study set usually found expressions of optimism regarding clinical trial results or the likelihood of FDA approval to be forward-looking statements protected under the Reform Act’s safe harbor where the statements were accompanied by specific cautionary language that warned investors of the most significant risks. As one court explained:

“Projections about the likelihood of FDA approval are forward-looking statements. They are assumptions related to the company’s plan for its product, and as such fall under the PSLRA’s safe harbor rule. Each VIVUS press release or other public statement cited by plaintiff included warnings about the uncertainties of forward-looking statements, and also referred to VIVUS’ SEC filings. Those filings, in turn, were replete with discussion of risk factors, including potential difficulties with obtaining FDA clearances and approval; the known side-effects of Qnexa’s two components, and the possibility of FDA required labeling restrictions; the risk that the FDA might require additional, expensive trials; and concerns regarding Qnexa’s association with Fen-Phen.”

In fact, some courts found optimistic projections to be protected even where the cautionary language was fairly minimal. For example, in Oppenheim v. Encysive Pharmas., Inc., 2007 WL 2720074 (S.D. Tex. Sep. 18, 2007), the court concluded that statements by the defendant (1) that it had a “good shot” at receiving priority review from the FDA (but where it had clearly acknowledged that it was “an FDA decision of course”), and (2) that it did not expect the FDA to require additional clinical trials (but where it had stated “you never know what’s going to happen when you get into a regulatory process”), were protected under the safe harbor. Id. at *3.

3. Challenges to clinical methodology and analysis are generally rejected, as long as the defendants do not appear to have been manipulating data.

Courts also routinely dismiss challenges to a company’s clinical methodology or analysis. Statements interpreting clinical trial results often are found to be non-actionable expressions of opinion. See, e.g., Corban v. Sarepta, 2015 WL 1505693, at *6 (D. Mass. Sep. 30, 2015) (applying pre-Omnicare standard and dismissing claims re statements touting the strength of clinical trial results in part because “many of the challenged statements consist of interpretations of the company’s data,” which the court found to be nonactionable expressions of opinion).

Likewise, courts tend to dismiss suits where plaintiffs’ theory boils down to a mere disagreement with the company’s clinical trial methodology. See, e.g., Davison v. VentrusBiosciences, Inc., 2014 WL 1805242, at *7 (S.D.N.Y. May 5, 2014) (dismissing claims that optimistic statements were misleading because they failed to disclose that the small sample size allegedly distorted results, and noting that “[t]he Second Circuit has emphasized that in scrutinizing a Section 10(b) claim, a court does not judge the methodology of a drug trial, but whether a defendant’s statements about that study were false and misleading”); In re Keryx Biopharmas., Inc., 2014 WL 585658, at *10-12 (S.D.N.Y. Feb. 14, 2014) (dismissing claims based on statements re clinical results that plaintiffs allege were misleading due to extensive methodological flaws); Abely v. Aeterna Zentaris, Inc., 2013 WL 2399869, at *6-10 (S.D.N.Y. May 29, 2013) (dismissing claims because plaintiff’s allegations “merely amount to a competing view of how the trial should have been designed” and “[p]ublic statements about clinical studies need not incorporate all potentially relevant information or findings, or even adhere to the highest research standards, provided that its findings and methods are described accurately”). As long as a biotech company describes its clinical and interpretive methodologies accurately, courts generally will not pass judgment on the soundness of those approaches. See id. at *6 (“The Second Circuit and other tribunals have concluded that the securities laws do not recognize a fraud claim premised on criticisms of a drug trial’s methodology, so long as the methodology was not misleadingly described to investors.” (emphasis added)).

Thus, it is best for biotech companies accurately to disclose the details of their clinical trial methodology and underlying data along with the company’s interpretation of that data, in order to avoid plausible claims of subterfuge later on.

C. Other than cases where companies appear to have made false statements of fact, the riskiest areas for companies are disclosures made relative to FDA feedback.

One category of statements sticks out in the study set as particularly troublesome for defendants: alleged misrepresentations concerning feedback from or interactions with the FDA. On the one hand,

“[N]umerous courts have concluded that a defendant pharmaceutical company does not have a duty to reveal interim FDA criticism regarding study design or methodology. Indeed, such courts frequently reason that interim FDA feedback is not material because dialogue between the FDA and pharmaceutical companies remain ongoing throughout the licensing process, rendering such criticism subject to change and not binding in regards to ultimate licensing approval.”

Vallabhaneni v. Endocyte, Inc., 2016 WL 51260, at *12 (S.D. Ind. Jan. 4, 2016) (dismissing claims that defendant misled investors by touting Phase II results without disclosing that the FDA had questioned how efficacy was determined in the study, because FDA concerns expressed were not so severe as to suggest the drug could not be approved, and the FDA subsequently allowed Phase III to move forward). See also Tongue v. Sanofi, 815 F.3d 199, 214 (2d Cir. 2016) (affirming dismissal) (“Reasonable investors understand that dialogue with the FDA is an integral part of the drug approval process, and no sophisticated investor familiar with standard FDA practice would expect that every view of the data taken by Defendants was shared by the FDA.”).

On the other hand, claims concerning statements or omissions about interactions with the FDA seem to survive motions to dismiss more often than other types of statements in biotech cases, perhaps because companies too often cherry-pick the FDA feedback they choose to disclose.

In assessing these sorts of claims, courts carefully distinguish between optimistic projections regarding approval, which tend to be protected forward-looking statements, and statements regarding past FDA interactions or feedback, which pertain to verifiable historical facts. For example, in In re Mannkind Sec. Actions, 835 F. Supp. 2d 797 (C.D. Cal. 2011), the court refused to dismiss claims regarding defendants’ repeated assurances that the FDA had “blessed,” “approved,” “accepted,” and “agreed to” the company’s methodological approach in its clinical trials, when it later became clear that the FDA had done no such thing:

“Courts must of course be careful to distinguish between forward-looking statements later deemed to be unduly optimistic, and statements of historical fact later shown to be false when made…

… [S]tatements touting the merits of the bioequivalency studies, can be fairly read as misguided opinion or ‘corporate optimism,’ [but] it is harder to escape the conclusion that Defendants’ statements concerning the FDA cross the line from exaggeration and ‘corporate optimism’ into outright misstatement of historical fact.”

Id. at 809-11 (emphasis in original).

Likewise, in In re Cell Therapeutics, Inc.Class Action Lit., 2011 WL 444676 (W.D. Wa. Feb. 4, 2011), the court dismissed claims challenging the defendants’ optimistic statements about the drug candidate’s progress in clinical trials and the company’s hopes for FDA approval because these were forward-looking statements accompanied by sufficient cautionary language. Id. at *7-8. At the same time, however, the court allowed claims to move forward regarding defendants’ repeated statements indicating that its Special Protocol Assessment (“SPA”)—an agreement with the FDA that the drug would be approved if the company followed the agreed-upon protocol and the drug proved effective[viii]—was still in effect even after defendants knew that they had invalidated the SPA. Id.; see also, e.g., Frater v. Hemispherx Biopharma, Inc., 996 F. Supp. 2d 335, 346 (E.D. Pa. 2014) (declining to dismiss claims re statements that allegedly mischaracterized FDA feedback by (1) omitting FDA statements indicating that it probably would not be receptive to company’s intended clinical approach and (2) incorrectly stating that the FDA had withdrawn its request for a new clinical trial as part of a resubmitted New Drug Application).

In light of these cases, how does a company decide what to disclose when it is in constant communications with the FDA? This is a prime area where a company can mitigate its risk by getting expert disclosure advice. As a starting point, review of our case study set suggests the following:

Context and clarity are important.Omnicare will protect statements of opinion so long as they are genuinely held and not misleading in their full context. If a company wants to express an opinion regarding its interactions with the FDA, it can protect itself by accurately and clearly disclosing the important underlying facts (positive and negative) regarding that interaction as well. Moreover, if a company wants to make optimistic projections regarding the approval process more generally, it should keep in mind that any negative feedback from the FDA, whether disclosed or not, will be part of the overall context in which those statements of opinion are judged.

Companies need to be careful not to mislead. Selective disclosure of some facts but not others can create difficulties and must be done with care and transparency. If a company chooses to disclose interim FDA feedback, it should do so fairly, reporting both positive and significant negative components of that feedback at the same time. With expert guidance, it is possible to emphasize the positive while acknowledging the negative in a way that will not leave the company open to challenge at a later date.

Companies should be careful not to overstate or misconstrue FDA opinions. These can later be contradicted by the agency when an approval decision is made, opening the company up to allegations that it intentionally misrepresented the interim feedback it received. A biotech company most often will be best served by couching any optimism it wants to express in terms of the company’s opinions and expectations—rather than positively characterizing the FDA’s feelings or intentions—and sticking to accurate, factual accounts of FDA feedback.

IV. Conclusion

Our study shows that, contrary to popular belief, development-stage biotech companies actually have less to fear from federal securities cases than do many other types of corporate defendants that have a far easier time securing insurance coverage. Over the last decade, these cases have been dismissed at a high rate early in the litigation process, and even more so in recent years. Biotech startups may well end up being sued if and when their flagship products are not approved by the FDA, but courts are sympathetic to the inherent risks of the industry and seem primed to dismiss these suits when defendants can present a credible narrative of good faith conduct. By getting expert disclosure advice before making important announcements, and by hiring litigation counsel who will affirmatively tell the company’s story at the motion to dismiss stage, small biotech companies and their insurers can guard against litigation and give the company an excellent shot at early dismissal in any securities suits that are ultimately brought against them.

Endnotes

[i] Specifically, we applied the following, over-inclusive search terms to all federal district court decisions from March 6, 2005 through October 3, 2016 in the Westlaw database: (pslra “private securities litigation reform”) & (FDA “food and drug administration” f.d.a.) /p (clinical medical bio! biotech! genom! gene genetic phase trial drug study therapy treatment) & “motion to dismiss.” This produced 298 results, only 61 of which met our study set criteria as described above (additional cases met the same criteria except that they were brought against companies that already had at least one drug or device on the market).

[ii] In each case, only the district court’s final decision on the defense’s motion(s) to dismiss was included in the study set. Any earlier dismissals, where plaintiffs were allowed to amend the complaint and the court then ruled on a subsequent motion to dismiss, were excluded so that sequential opinions in the same action were not double-counted. Likewise, cases that did not yet have a final decision on the motion to dismiss were excluded (e.g., if the court initially dismissed with leave to amend and a subsequent motion to dismiss was pending).

[iii] Decisions where the securities fraud claims concerned something other than the clinical trial and FDA approval process for their primary drug or device candidate (e.g., alleged financial improprieties, marketing, sales, post-approval manufacturing issues, etc.) were not included in the study set.

[iv]See Svetlana Starykh & Stefan Boettrich, NERA Economic Consulting, Recent Trends in Securities Class Action Litigation: 2015 Full-Year Review, at 19, available at http://www.nera.com/content/dam/nera/publications/2016/2015_Securities_Trends_Report_NERA.pdf (only 54% of the securities class action motions to dismiss that were resolved between January and December 2015 were granted, with or without prejudice).

[vi] The Reform Act provides a safe harbor for forward-looking statements that are identified as such and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” 15 U.S.C. § 78u–5(c)(1)(A)(i).

[vii] This district court dismissal was excluded from our primary study set because, although it otherwise met our study criteria, Sanofi is a well-established pharmaceutical company with numerous drugs already on the market.

[viii] As the court explained: “[A]n SPA can only be modified by written agreement between the FDA and the sponsor and then only if it is intended to improve the study. Failure to follow the agreed-upon protocol constitutes an understanding that the SPA is no longer binding.” In re Cell Therapeutics, 2011 WL 444676, at *1.

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The villain in the fight against securities class actions is the fraud-on-the-market presumption of reliance established by the U.S. Supreme Court in 1988 in Basic Inc. v. Levinson, 485 U.S. 224 (1988). Without Basic, the thinking goes, a plaintiff could not maintain a securities class action, and without securities class actions, executives could speak their minds without worrying so much about securities law liability. In the current environment, the risk of further attacks on Basic seems high. (A general class action reform bill, the “Fairness in Class Action Litigation Act of 2017,” has already been introduced in the House—analyzed by Alison Frankel here, and by Kevin LaCroix here.)

But Basic ballasts the system of securities-law enforcement by protecting investors, while providing companies with predictable procedures and finality upon settlement. We have a lead plaintiff and class representative who prosecutes a claim that defendants can settle with a broad class-wide release. Because the private plaintiffs’ bar is doing its job, the SEC stays away in most cases. Honest executives have nothing to fear with the current system—they routinely get through securities litigation without any real reputational or personal financial risk.

On the other hand, without Basic, plaintiffs’ lawyers would still file securities litigation. In place of class actions, each plaintiffs’ firm would file an individual or multi-plaintiff collective action, resulting in multiple separate actions in courts around the country. These would be difficult to manage, expensive to defend, and impossible to settle with finality until the statute of limitations expires. SEC enforcement would become more frequent. Companies and their D&O insurers and brokers would be unable to predict and properly insure against the risk of a disclosure problem.

Moreover, I have never understood the supposed benefits of abolishing Basic. Although it is possible that the frequency of securities litigation would decline, I doubt it would. A disclosure problem that would trigger a securities class action today would result in at least several non-class securities actions in a post-Basic system.

And any decrease in frequency would come at a high cost—in addition to the increased cost of defending and resolving those cases that are filed, investors and the economy would suffer from more securities fraud resulting from the diminished deterrence that class actions provide. Even an executive who detests securities class actions pictures prominent plaintiffs’ lawyers when he or she decides whether to omit an important fact.

So, to those who bash Basic, be careful what you wish for.

A Brief History of the Fraud-on-the-Market Doctrine

The fraud-on-the-market doctrine concerns the reliance element of a Section 10(b) claim. Absent some way to harmonize individual issues of reliance, class treatment of a securities class action is not possible; individual issues overwhelm common ones, precluding certification under Federal Rule of Civil Procedure 23(b)(3). In Basic, the Supreme Court provided a solution: a rebuttable presumption of reliance based on the fraud-on-the-market theory, which provides that a security traded on an efficient market reflects all public material information. Purchasers (or sellers) rely on the integrity of the market price, and thus on a material misrepresentation. Decisions following Basic have established three conditions to its application: market efficiency, a public misrepresentation, and a purchase (or sale) between the misrepresentation and the disclosure of the “truth.”

Over the years, defendants have argued that, absent a showing by plaintiffs that the challenged statements were material, or upon a showing by defendants that they were not, the presumption is not applicable or has been rebutted. And, in a twist on such arguments, defendants sometimes argued that the absence of loss causation rebutted the presumption. In Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011), the Supreme Court unanimously rejected the latter argument, finding that loss causation is not a condition of the presumption of reliance. But the Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply.

Later, the Court granted certiorari in Amgen Inc. v. Conn. Ret. Plans and Trust Funds, 133 S. Ct. 1184 (2013), to review the Ninth Circuit’s decision that plaintiffs are not required to prove materiality for the presumption to apply, and that the district court is not required to allow defendants to present evidence rebutting the applicability of the presumption before certifying a class. In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the AmgenCourt concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.”

As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand. The district court certified a class, prior to the Supreme Court’s decision in Amgen. Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen. The Halliburton case ended up before the Supreme Court once again, this time with the viability of Basic squarely presented. The Court rejected Halliburton’s argument that Basic is inconsistent with modern economic theory, under which market efficiency is not a binary “yes or no” issue. Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014). Thus, Basic survived the Halliburton battle.

What Would Securities Litigation Look Like without Basic?

Our current securities class action system is straightforward and predictable. Like any other action, a securities class action starts with the filing of a complaint by a plaintiff. But after that, the procedure for these actions is unique. The Reform Act mandates that the first plaintiff to file a securities class action publish a press release giving notice of the lawsuit and advising class members that they can attempt to be the “lead plaintiff” by filing a motion with the court within 60 days of the press release. Additional plaintiffs will often file their own complaints in advance of the deadline, or they may simply file a motion to become lead plaintiff at the deadline.

The Reform Act provides that the “presumptively most adequate lead plaintiff” is the one who “has the largest financial interest in the relief sought by the class” and otherwise meets the requirements of Rule 23 of the Federal Rules of Civil Procedure, which governs class actions. The Reform Act’s standards for lead plaintiff selection have caused plaintiffs’ firms to pursue institutional investors and pension funds as plaintiffs, since they are more likely to be able to show the financial interest necessary to be designated as lead plaintiffs. But as I have chronicled, in recent years, smaller plaintiffs’ firms have won lead-plaintiff contests with retail investors as lead plaintiffs, primarily in securities class actions against smaller companies. About half of all securities class actions are filed against smaller companies by these smaller plaintiffs’ firms.

This deeper and more diverse new roster of plaintiffs’ firms means that securities litigation won’t just go away if they can’t file securities class actions. The larger plaintiffs’ firms have strong client relationships with the institutional investors the Reform Act incentivized them to develop. Claims by the retail investors that the Reform Act sought to replace have made a resurgence through relationships with smaller plaintiffs’ firms. Together, these plaintiffs and plaintiffs’ firms fully cover the securities litigation landscape. These firms are competitive with one another. One will rush to file a case, and if one files, others will too. They are specialized securities lawyers, and they aren’t going to become baristas or bartenders if Basic is abolished. They will seek out cases to file.

So the plaintiffs’ bar would adjust, just as they have adjusted to limited federal-court jurisdiction under Morrison v. National Australia Bank, 561 U.S. 247 (2010). And if the post-Morrison framework is any indication of what we would face post-Basic, look out—Morrison has caused the proliferation of unbelievably expensive litigation around the world, without the ability to effectively coordinate or settle it for a reasonable amount with certain releases.

In a post-Basic world, the plaintiffs’ firms with institutional investor clients would likely file large individual and non-class collective actions. Smaller plaintiffs’ firms would also file individual and non-class collective actions. The damages in cases filed by smaller firms would tend to be smaller, but the litigation burdens would be similar.

Non-class securities actions would be no less expensive to defend than today’s class actions, since they would involve litigation of the same core merits issues. In fact, non-class litigation would be even more expensive in certain respects because, for example, there would be multiple damages analyses and vastly more complex case management. And if securities class action opt-out litigation experience is indicative of the settlement value of such cases, they would tend to settle for a larger percentage of damages than today’s securities class actions.

In a new non-class era of securities litigation, the settlement logistics would be vastly more difficult. It’s hard enough to mediate with one plaintiffs’ firm and one lead plaintiff. Imagine mediation with a dozen or more plaintiffs’ firms and even more plaintiffs. We often object to lead-plaintiff groups because of the difficulty of dealing with a group of plaintiffs instead of just one. In a world without securities class actions, the adversary would be far, far worse—a collection of plaintiffs and plaintiffs’ firms with no set of rules for getting along.

Even when settlement could be achieved, it wouldn’t preclude suits by other purchasers during the period of inflation, because there would be no due process procedure to bind them, as there is when there’s a certified class with notice and an opportunity to object or opt out. Indeed, there likely would develop a trend of random follow-up suits by even smaller plaintiffs’ firms after the larger cases have settled. There would be no peace absent the expiration of the statute of limitations.

These unmanageable and unpredictable economics would disrupt D&O insurance purchasing decisions and cost. Under the current system, D&O insurers and brokers can reliably predict the risk a particular company faces based on its size and other characteristics. A company can thus purchase a D&O insurance program that fits its risk profile.

Compounding the uncertainty of all of this would be the role of SEC and other government enforcement. Even with the current U.S. administration’s relatively hands-off regulatory approach, the job of the human beings who work at the SEC is to investigate and enforce the securities laws. They aren’t going to not do their jobs just because government regulation has been eased in the bigger picture. And they will step in to fill the void left by the inability of plaintiffs to bring securities class actions. Experienced defense counsel can predict how plaintiffs’ firms will litigate and resolve a case, but they have much less ability to predict how an enforcement person with whom he or she may never have dealt will approach a case.

Conclusion

Executives who do their best to tell the truth really have nothing to fear under the securities laws. The law gives them plenty of protection, and the predictability of the current system allows them to understand their risk and resolve litigation with certainty. It would be a mistake to try to abolish securities class actions. Abandoning Basic would backfire—badly.

The history of securities and corporate governance litigation is full of wishes about the law that we later regret (or will), or are happy were not granted. Many of these are not obvious—and some will surprise people. From certain case-by-case tactical decisions such as establishment of special litigation committees, to the (failed) attempt to abolish the fraud-on-the-market doctrine, to the very high standard for director liability for oversight failures, not everything that seems helpful to companies really is.

I will publish a series of blog posts on this topic over the coming months. This month’s post discusses the Private Securities Litigation Reform Act, with a focus on two provisions: the safe harbor for forward-looking statements (“Safe Harbor”), and lead plaintiff procedures.

Overview of the Reform Act

The Reform Act was passed by the Contract-with-America Congress to address its perception that securities class actions were reflexive, lawyer-driven litigation that often asserted weak claims based on little more than a stock drop, and relied on post-litigation discovery, rather than pre-litigation investigation, to sort out the validity of the claims. The Reform Act, among other things:

Imposed strict pleading standards for showing both falsity and scienter, to curtail frivolous claims by increasing the likelihood that they would be dismissed.

Created the Safe Harbor, to encourage companies to make forecasts and other predictions without undue fear of liability.

Imposed a stay of discovery until the motion-to-dismiss process is resolved, to prevent discovery fishing expeditions and to eliminate the burden of discovery for claims that do not meet the enhanced pleading standards.

Created procedures for selecting a lead plaintiff with a substantial financial stake in the litigation, to discourage lawyer-driven actions and the “race to the courthouse.”

Over my career as a securities litigator, I’ve seen both sides of the securities-litigation divide that the Reform Act created. In the first part of my career, I witnessed the figurative skid marks in front of courthouses, as lawyers raced to the courthouse to file claims before knowing if there really was a claim to be filed—the emblem of the problems Congress sought to correct. And in the 21 years since, I’ve seen the Reform Act both succeed and fail to achieve the results Congress intended.

Having lived the before and after, I would not argue that the Reform Act has not helped companies and their directors and officers. It certainly has. But it is a mixed bag. Indeed, I can argue that even the heightened falsity and scienter pleading standards have caused harm. For example, the pleading standards lead even the most prominent defense lawyers to rely heavily on the lack of words in a complaint—the securities litigation equivalent of “neener neener neener”—instead of using the complaint and judicially noticeable facts to cogently explain why the defendants didn’t say anything false, much less on purpose.

Over-reliance on the pleading standards is a strategic mistake. The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with little room to challenge their decisions upon appeal. Winning motions recognize the human element to this discretion. Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud. Effective motions use the leeway given to defendants by the Reform Act, and now the Supreme Court’s decisions in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), and Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to build a robust factual record that gives judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice. And even if the judge doesn’t dismiss the case, he or she will leave the motion to dismiss process with a better feeling about the case going forward. But the pleading standards can be an attractive nuisance, distracting defense lawyers from the best way to defend their clients.

The pleading standards have also spawned a sideshow of “confidential witnesses,” primarily former employees who provide plaintiffs’ lawyers with internal corporate information to help them meet the pleading standards. In addition to raising whistleblower issues, causing fights over misuse of confidential information, and airing dirty laundry, the use of confidential witnesses has resulted in fights between plaintiffs’ lawyers and recanting witnesses requiring judicial intervention.

In one especially contentious dispute, Judge Rakoff spent a day taking testimony from recanting witnesses and a plaintiffs’ investigator, and took additional time to write an opinion commenting on this issue after the parties had settled the litigation. He concluded his nine-page opinion as follows:

The sole purpose of this Memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants. It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate “private eyes” who would entice naïve or disgruntled employees into gossip sessions that might support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But, as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.

We may well see this problem as one of the underpinnings of a legislative attempt to reform the Reform Act one day.

In any event, and regardless of one’s views of the pleading standards’ overall benefits, two other Reform Act provisions certainly have grown to be problematic for public companies: the Safe Harbor, and the lead plaintiff provisions.

The Safe Harbor for Forward-Looking Statements

The Safe Harbor was a centerpiece of the Reform Act. Lawsuits prompted by announcements of missed earnings forecasts deterred companies from giving valuable earnings guidance. Congress sought to encourage guidance and other forward-looking statements by precluding liability if the statements were accompanied by “meaningful cautionary statements” or made without “actual knowledge” that they were false. 15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet the Safe Harbor is anything but safe. In the 21 years of the Reform Act, surprisingly few dismissals are based solely the Safe Harbor; instead, courts either use it as fallback grounds for dismissal, or just sidestep it—which has resulted in some significant legal errors. The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook, in Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004). Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results. Id. at 734.

The reason for this judicial antipathy was best articulated by Bill Lerach, who famously said that the Safe Harbor would give executives a “license to lie.” Judges have tended to agree with his conclusion. Some have been quite explicit about it. For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.” 414 F.3d 187, 212 (1st Cir. 2005). And the Second Circuit, in its first decision analyzing the Safe Harbor—15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance—correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the Safe Harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?” Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010). Probably for this reason, the Safe Harbor has not deterred plaintiffs’ counsel from continuing to bring false forecast cases. Twenty-one years later, a great many securities class actions still focus on earnings forecasts and other forward-looking statements.

Much of this problem is self-inflicted. We defense lawyers have worsened the judicial antipathy and reluctance to issue rulings on Safe Harbor grounds by making hyper-technical arguments that are detached from any notion that the challenged forward-looking statements aren’t false in the first place. Most challenged forward-looking statements are true statements of opinion—an especially strong argument under the Supreme Court’s Omnicare decision—and don’t even need the Safe Harbor’s protection. But by bypassing the falsity argument, and falling back on the Safe Harbor, defense counsel plays right into plaintiffs’ hands. Many defense lawyers try to overcome this problem by emphasizing that Congress intended to immunize even unfair forward-looking statements, if they are accompanied by appropriate warnings. But judges don’t like caveat emptor, and they don’t like liars—regardless of Congressional intent. A much better way to defend forward-looking statements is to show that they were true statements of opinion and then use the Safe Harbor as a fallback argument. It makes the judge feel comfortable dismissing the claim in either or both ways. But few defense lawyers take that approach.

Finally, companies and their outside corporate counsel have contributed to the Safe Harbor’s lack of safety by failing to describe their risks in a fresh and detailed way each quarter. When I evaluate a securities class action complaint that challenges forward-looking statements and other statements of opinion (which comprise nearly all securities cases), one of the first things I look for is the progression of the risk factors each quarter. Using a chart, I read them from start to finish, just as the judge will when we create the context for our arguments against falsity and to support the application of the Safe Harbor. Are the risk factors specific or generic? Do they change over time or are they static? Do the changes in the risk factors track disclosed changes in business conditions? Etc. But companies and their outside corporate counsel frequently devolve to boilerplate, and fail to draft careful disclosures that make a judge feel comfortable that they were trying to disclose their real risks each quarter.

Lead Plaintiff Procedures

The symbol of the pre-Reform Act era is the race to the courthouse among plaintiffs’ lawyers to file a complaint first and thus win the lead counsel role. Congress intended the heightened pleading standards and the Safe Harbor to play a role in fixing that problem, because they are meant to incentivize plaintiffs to do more pre-filing investigation. However, the Reform Act’s lead plaintiff provisions—which require the court to choose a lead plaintiff and lead plaintiff’s counsel after a beauty contest—undermine that goal, since only the lead plaintiff has an economic incentive to invest much time and money in an investigation. So although the initial filer no longer has a competitive advantage by being the first plaintiff to file, the initial complaint is still routinely filed without any real investigation or worry about satisfying the pleading standards.

The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss—i.e., a plaintiff with “skin in the game.” While that goal is salutary, it has spawned complex and mixed results. The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual retail investor clients who usually can’t beat out institutions for the lead plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount of cases that survive dismissal motions is fairly low. These dynamics placed a premium on experience, efficiency, and scale. Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

But nature abhors a vacuum—here, a securities litigation system that leaves out retail investors and smaller plaintiffs’ firms. So, it was inevitable that these alienated groups would find a way to bring securities class actions. As I’ve chronicled previously, this void started to be filled with the wave of cases against Chinese issuers in 2010. Smaller plaintiffs’ firms initiated the lion’s share of these cases, primarily on behalf of retail investors, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

With these gains in efficiency, market share, and money, these smaller plaintiffs’ firms have continued to file a large number of securities class actions on behalf of retail investors. Like the China cases, these tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs—for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

We now have two classes of prominent plaintiffs and plaintiffs’ firms: larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace. In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.

Smaller plaintiffs’ firms’ permanent arrival on the scene has led to two sets of additional problems.

First, smaller plaintiffs’ firms have ratcheted up the number of press releases by plaintiffs’ firms seeking plaintiffs to file a securities class action. There have always been plaintiff law firm “investigations” to try to find plaintiffs to file lawsuits, but there has been nothing short of an avalanche in recent years. This is so for a number of reasons. Unlike larger plaintiffs’ firms that have spent 21 years cultivating institutional investor clients as the Reform Act envisioned, smaller plaintiffs’ firms generally don’t have existing attorney-client relationships with potential plaintiffs who own a wide range of securities—so they need to recruit plaintiffs for particular cases. Smaller plaintiffs’ firm successes are drawing more smaller firms into the securities class action business. This competition is resulting in an “investigation” following nearly every negative corporate announcement. Increasingly, this is so even if the stock price drop is relatively small—indeed, I’ve seen more investigations and subsequent securities class actions follow single-digit stock drops than ever before, likely because the of the number of smaller-firm players and the reality that a small case is better than none. The press release process is repeated after a lawsuit is filed. As the Reform Act requires, the first filer publishes a press release announcing the filing. Other smaller plaintiffs’ firms then publish their own announcements that a lawsuit has been filed in order to find a good lead plaintiff contestant. Each firm publishes their own notice, and the firms then publish reminders leading up to the lead plaintiff filing deadline 60 days later.

To put it mildly, this process is a real nuisance, especially for smaller companies. Investors, employees, and other stakeholders who don’t understand this process sometimes perceive that the company is falling apart. Dealing with their concerns can cause officers and directors to become distracted. The result can be further deterioration of the company’s business and financial condition, and an unwarranted sell-off of the company’s stock. This can be about more than money—for example, development of life-saving drugs can be slowed or even derailed. Obviously, none of that is good. I doubt the plaintiffs’ lawyers themselves would disagree, but instead would say that they’re simply working under the Reform Act’s lead plaintiff procedures.

Second, the fervent competition among smaller plaintiffs’ firms is affecting the types of cases filed and settlement dynamics. Although the smaller plaintiffs’ firms’ bread-and-butter are “lawsuit blueprint” cases that often have difficult facts, they are also filing many low-merit cases, such as challenges to earnings guidance. At the same time, the intense competition sometimes results in more difficult and protracted litigation, meritorious or not. There are usually other smaller plaintiffs’ firms on the scene through tag-along derivative suits or as co-lead securities class action counsel, and none of the firms wants the others to see it as a pushover for wanting to settle for an amount they’d otherwise gladly take. That said, it’s also true that smaller plaintiffs’ firms are defeating an increasing number of motions to dismiss and can be formidable adversaries—which of course gives them greater leverage and leads to more difficult litigation to defend and resolve.

Conclusion

Although these issues won’t make the legislative agenda anytime soon, we defense lawyers can make a difference. We can:

Emphasize the truth of the challenged statements through the tools the Reform Act and Supreme Court have provided, and avoid over-reliance on the Safe Harbor and pleading standards.

Ask courts to impose clear leadership and coordination between and among securities class action and derivative plaintiffs’ counsel.

Educate companies about the reasons for the frustrating flurry of press releases.

Following is an article I wrote for Law360, which gave me permission to republish it here:

Among securities litigators, there is no consensus about the importance of developments in securities and corporate governance litigation. For some, a Supreme Court decision is always supreme. For others, a major change in a legal standard is the most critical. For me, the key developments are those that have the greatest potential to significantly increase or decrease the frequency or severity of claims against public companies and their directors and officers.

Given my way of thinking, there are three developments in 2016 that stand out as noteworthy:

The persistence of securities class actions brought against smaller public companies primarily by smaller plaintiffs’ firms on behalf of retail investors—a trend that began five years ago and now appears to represent a fundamental shift in the securities class action landscape.

The 2nd Circuit’s robust application of the Supreme Court’s Omnicare decision in Sanofi, illustrating the significant benefits of Omnicare to defendants.

The demise of disclosure-only settlements under the Delaware Court of Chancery’s Trulia decision and the 7th Circuit’s subsequent scathing Walgreen opinion by Judge Posner.

I discuss each of these developments in detail, and then list other 2016 developments that I believe are important as well.

1. The Securities Class Action Landscape Has Fundamentally Changed

The Private Securities Litigation Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, have retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount of cases that survive dismissal motions is fairly low. These dynamics placed a premium on experience, efficiency, and scale. Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

This started to change with the wave of cases against Chinese companies in 2010. Smaller plaintiffs’ firms initiated the lion’s share of these cases, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well. Nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate was low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

The smaller plaintiffs’ firms thus built up momentum that has kept them going, even after the wave of China cases subsided. For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases. Like the China cases, these cases tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems (reducing the plaintiffs’ firms’ investigative costs) for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors. To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want. But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.

The securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors. This change—now more than five years old—appears to be here to stay.

In addition to this fundamental shift, two other trends are an indicator of further changes to the securities litigation landscape.

First, the smaller plaintiffs’ firms often file cases against U.S. companies in New York City or California—regardless where the company is headquartered—diverging from the larger plaintiffs’ firms’ practice of filing in the forum of the defendant company’s headquarters. In addition to inconvenience, filing cases in New York City and California against non-resident companies results in sticker-shock, since defense firms based in those venues are much more expensive than their home town firms. The solution to this problem will need to include greater defense of cases in New York City and California by a more economically diverse set of defense firms.

Second, plaintiffs’ firms, large and small, are increasingly rejecting the use of historical settlement values to shape the settlement amounts. This practice is increasing settlement amounts in individual cases, and will ultimately raise settlement amounts overall. And it will be increasingly difficult for defendants and their insurers to predict defense costs and settlement amounts, as more mediations fail and litigation proceeds past the point they otherwise would.

As a reminder, the Supreme Court in Omnicare held that a statement of opinion is only false under the federal securities laws if the speaker does not genuinely believe it, and is only misleading if it omits information that, in context, would cause the statement to mislead a reasonable investor. This ruling followed the path Lane Powell advocated in an amicus brief on behalf of Washington Legal Foundation.

The Court’s ruling in Omnicarewas a significant victory for the defense bar for two primary reasons.

First, the Court made clear that an opinion is false only if it was not sincerely believed by the speaker at the time that it was expressed, a concept sometimes referred to as “subjective falsity.” The Court thus explicitly rejected the possibility that a statement of opinion could be false because “external facts show the opinion to be incorrect,” because a company failed to “disclose[] some fact cutting the other way,” or because the company did not disclose that others disagreed with its opinion. This ruling resolved two decades’ worth of confusing and conflicting case law regarding what makes a statement of opinion false, which had often permitted meritless securities cases to survive dismissal motions. Omnicare governs the falsity analysis for all types of challenged statements. Although Omnicarearose from a claim under Section 11 of the Securities Act, all of its core concepts are equally applicable to Section 10(b) of the Securities Exchange Act and other securities laws with similar falsity elements.

Second, Omnicare declared that whether a statement of opinion (and by clear implication, a statement of fact) was misleading “always depends on context.” The Court emphasized that showing a statement to be misleading is “no small task” for plaintiffs, and that the court must consider not only the full statement being challenged and the context in which it was made, but must also consider other statements made by the company, and other publicly available information, including the customs and practices of the relevant industry.

A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it’s not false or misleading. But many defense lawyers unfortunately leave out the broader context, and courts have sometimes taken a narrower view. Now, this type of superior, full-context analysis is clearly required by Omnicare. And combined with the Supreme Court’s directive in Tellabs that courts consider scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice, courts clearly must now consider the full array of probative facts in deciding both whether a statement was false or misleading and, if so, whether it was made with scienter.

Due to the importance of its holdings and the detailed way in which it explains them, Omnicareis the most significant post-Reform Act Supreme Court case to analyze the falsity element of a securities class-action claim, laying out the core principles of falsity in the same way that the Court did for scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). If used correctly, Omnicare thus has the potential to be the most helpful securities case for defendants since Tellabs, providing attorneys with a blueprint for how to structure their falsity arguments in order to defeat more complaints on motions to dismiss.

The early returns show that Omnicare is already helping defendants win more motions to dismiss. The most significant such decision is Sanofi. In Sanofi, the Second Circuit became the first appeals court to discuss Omnicare in detail, and to examine the changes that it brought about in the previously governing law. Sanofi was not, as some securities litigation defense lawyers have claimed, a “narrow” reading of the Court’s decision. Rather, it was a straightforward interpretation of Omnicare that emphasized the Supreme Court’s ruling on falsity, and the intensive contextual analysis required to show that a statement is misleading. It correctly took these concepts beyond the Section 11 setting and applied them to allegations brought under Section 10(b).

Statements about Lemtrada, a drug in development for treatment of multiple sclerosis, were at issue in the case. Sanofi and its predecessor had conducted “single-blind” clinical trials for Lemtrada (studies in which either the researcher or the patient does not know which drug was administered), despite the fact that the U.S. Food and Drug Administration had repeatedly expressed concerns about these trials and recommended “double-blind” clinical studies (studies in which both the researcher and the patient do not know which drug was administered).

The plaintiffs alleged that Sanofi’s failure to disclose FDA’s repeated warnings that a single-blind study might not be adequate for approval caused various statements made by the company to be misleading, including its projection that FDA would approve the drug, its expressions of confidence about the anticipated launch date of the drug, and its view that the results of the clinical trials were “unprecedented” and “nothing short of stunning.” Although FDA eventually approved Lemtrada without further clinical trials, the agency initially refused approval based in large part on the single-blind studies concern, causing a large drop in the price of Sanofi stock.

In an opinion issued before Omnicare, the district court dismissed the claims, in part because it found that plaintiffs had failed to plead that the challenged statements of opinion were subjectively false, under the standard employed by the Second Circuit in Fait v. Regions Financial Corp. The Second Circuit stated that it saw “no reason to disturb the conclusions of the district court,” but wrote to clarify the impact of Omnicare on prior Second Circuit law.

The court acknowledged that Omnicare affirmed the previous standard that a statement of opinion may be false “if either ‘the speaker did not hold the belief she professed’ or ‘the supporting fact she supplied were untrue.’” However, it noted that Omnicare went beyond the standard outlined by Fait in holding that “opinions, though sincerely held and otherwise true as a matter of fact, may nonetheless be actionable if the speaker omits information whose omission makes the statement misleading to a reasonable investor.”

In reality, Omnicare did not represent a change in Second Circuit law. Although Fait only discussed falsity, without considering what it would take to make an opinion “misleading,” prior Second Circuit law had been clear that “[e]ven a statement which is literally true, if susceptible to quite another interpretation by the reasonable investor, may properly be considered a material misrepresentation.” Kleinman v. Elan Corp., 706 F.3d 145 (2nd Cir. 2013) (citation and internal quotation marks omitted). Omnicare simply brought together these two lines of authority, by correctly clarifying that, like any other statement, a statement of opinion can be literally true (i.e., actually believed by the speaker), but can nonetheless omit information that can cause it to be misleading to a reasonable investor.

The Second Circuit highlighted the Omnicare Court’s focus on context, taking note of its statement that “an omission that renders misleading a statement of opinion when viewed in a vacuum may not do so once that statement is considered, as is appropriate, in a broader frame.” Since Sanofi’s offering materials “made numerous caveats to the reliability of the projections,” a reasonable investor would have considered the opinions in light of those qualifications. Similarly, the Second Circuit recognized that reasonable investors would be aware that Sanofi would be engaging in continuous dialogue with FDA that was not being disclosed, that Sanofi had clearly disclosed that it was conducting single-blind trials for Lemtrada, and that FDA had generally made clear through public statements that it preferred double-blind trials. In this broader context, the court found that Sanofi’s optimistic statements about the future of Lemtrada were not misleading even in the context of Sanofi’s failure to disclose FDA’s specific warnings regarding single-blind trials.

Under the Omnicare standards, the Second Circuit thus found nothing false or misleading about the challenged statements, holding that Omnicare imposes no obligation to disclose facts merely because they tended to undermine the defendants’ optimistic projections. In particular, the Second Circuit found that “Omnicare does not impose liability merely because an issuer failed to disclose information that ran counter to an opinion expressed in a registration statement.” It also reasoned that “defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.”

3. Companies May Regret the Decline of Disclosure-Only Settlements

In combination with the Delaware Court of Chancery’s decision in In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016), Judge Posner’s blistering opinion In re Walgreen Company Stockholder Litigation, 2016 WL 4207962 (7th Cir. Aug. 10, 2016), may well close the door on disclosure-only settlements in shareholder challenges to mergers. That certainly feels just. And it may well go a long way toward discouraging meritless merger litigation. But I am concerned that we will regret it. Lost in the cheering over Trulia and Walgreen is a simple and practical reality: the availability of disclosure-only settlements is in the interests of merging companies as much as it is in the interests of shareholder plaintiffs’ lawyers, because disclosure-only settlements are often the timeliest and most efficient way to resolve shareholder challenges to mergers, even legitimate ones.

I am offended by meritless merger litigation, and have long advocated reforms to fix the system that not only allows it, but encourages and incentivizes it. Certainly, strict scrutiny of disclosure-only settlements will reduce the number of merger claims—it already has. Let’s say shareholder challenges to mergers are permanently reduced from 90% to 60% of transactions. That would be great. But how do we then resolve the cases that remain? Unfortunately, there aren’t efficient and generally agreeable alternatives to disclosure-only settlements to dispose of a merger lawsuit before the closing of the challenged transaction. Of course, the parties can increase the merger price, though that is a difficult proposition. The parties can also adjust other deal terms, but few merger partners want to alter the deal unless and until the alteration doesn’t actually matter, and settlements based on meaningless deal-structure changes won’t fare better with courts than meaningless disclosure-only settlements.

If the disclosure-only door to resolving merger cases is shut, then more cases will need to be litigated post-close. That will make settlement more expensive. Plaintiffs lawyers are not going to start to settle for less money, especially when they are forced to litigate for longer and invest more in their cases. And in contrast to adjustments to the merger transaction or disclosures, in which 100% of the cash goes to lawyers for the “benefit” they provided, settlements based on the payment of cash to the class of plaintiffs require a much larger sum to yield the same amount of money to the plaintiffs’ lawyers. For example, a $500,000 fee payment to the plaintiffs under a disclosure-only settlement would require around $2 million in a settlement payment to the class to yield the same fee for the plaintiffs’ lawyers, assuming a 25% contingent-fee award.

The increase in the cash outlay required for companies and their insurers to deal with post-close merger litigation will actually be much higher than my example indicates. Plaintiffs’ lawyers will spend more time on each case, and demand a higher settlement amount to yield a higher plaintiffs’ fee. Defense costs will skyrocket. And discovery in post-close cases will inevitably unearth problems that the disclosure-only settlement landscape camouflaged, significantly increasing the severity of many cases. It is not hard to imagine that merger cases that could have settled for disclosures and a six-figure plaintiffs’ fee will often become an eight-figure mess. And, beyond these unfortunate economic consequences, the inability to resolve merger litigation quickly and efficiently will increase the burden upon directors and officers by requiring continued service to companies they have sold, as they are forced to produce documents, sit for depositions, and consult with their defense lawyers, while the merger case careens toward trial.

Again, it’s hard to disagree with the logic and sentiment of these decisions, and the result may very well be more just. But this justice will come with a high practical price tag.

Additional Significant Developments

There were a number of other 2016 developments that I believe may also significantly impact the frequency and severity of securities claims against public companies and their directors and officers. These include:

The lack of a wave of cyber security shareholder litigation, and the conclusion in favor of the defendants in the Target and Home Depot shareholder derivative cases, which follows the dismissal of the Wyndham derivative case in 2014.

The challenge to the SEC’s use of administrative proceedings, including Lynn Tilton’s tilt at the process.

The 9th Circuit becoming the first appellate court to hold that Section 304 of Sarbanes-Oxley allows the SEC to seek a clawback of compensation from CEOs and CFOs in the event of a restatement even if it did not result from their misconduct. U.S. Securities & Exchange Commission v. Jensen, 835 F.3d 1100 (2016).

Earlier this month, I spent a week in the birthplace of D&O insurance, London. In addition to moderating a panel at Advisen’s European Executive Risks Insights Conference, I met with many energetic and talented D&O insurance professionals, both veterans and rising stars, to discuss U.S. securities litigation and regulatory risks. Themes emerged on some key issues. What follows is a collection of my impressions and opinions about three of them—not quotes from any particular company or person.

As I’ve observed over the past several years, a significant risk to companies is that ever-increasing securities defense fees no longer match the economics of most cases, and are quickly outpacing D&O policy limits. In the past, securities class actions were initiated by an oligopoly of larger plaintiffs’ firms with significant resources and mostly institutional clients that tended to bring larger cases against larger companies. But in recent years, smaller plaintiffs’ firms with retail-investor clients have been initiating more cases, primarily against smaller companies. Indeed, in recent years, approximately half of all securities class actions were filed against companies with $750 million or less in market capitalization. As a result, securities class actions have shrunken in size to a level last seen in 1997.

Yet at the same time, the litigation costs of the typical defense firms (mainly firms with marquee names) have increased exponentially. This two-decade mismatch—between 1997 securities-litigation economics and present-day law-firm economics—creates the danger that a company’s D&O policy will be insufficient to cover the fees for a vigorous defense and the price to resolve the case. Indeed, in my view, inadequate policy proceeds due to skyrocketing defense costs is the biggest risk directors and officers face from securities litigation—by far.

D&O insurers face a double-whammy: They are paying defense costs on smaller claims that are out of proportion to the actual risk because the lion’s share of cases against all companies, both large and small, are defended by the typical defense firms. At the same time, insurers are unable to charge a sufficient premium for this risk, due to the softness of the market.

I strongly believe the solution lies in a more tailored D&O insurance option for smaller public companies. Today, every public company buys some form of D&O indemnity insurance, which allows the company to choose their own lawyers and control their defense strategy. Under this approach, securities litigation defense lawyers effectively control the D&O insurance claims process; even the most veteran in-house lawyers are almost always securities litigation rookies. Is that in the insureds’ interest? Is the one-size-fits-all D&O insurance model right for smaller public companies, whose insurance proceeds are being disproportionately being spent on defense costs? Is there demand for an optional product that gives insurers greater control, up to and including an optional duty to defend D&O product for smaller companies?

London insurers and brokers are working through these issues. I’m extremely hopeful that there will be innovation for smaller public companies and their directors and officers—insureds who most need the guidance and protection of their insurance professionals.

2. In the wake of Morrison, greater strategic control is needed to deal with the risk of separate actions around the world.

In Morrison v. National Australia Bank, 561 U.S. 247 (2010), the U.S. Supreme Court held that the U.S. securities laws only apply to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” In the aftermath of the decision, it was widely assumed that the frequency of U.S. securities class actions against foreign issuers would decline. Yet it has not. For more background, I refer you to Kevin LaCroix’s September 26, 2016 post in his blog, The D&O Diary.

Despite Morrison, foreign issuers whose securities are traded in the U.S. are still subject to a securities class action with respect to those securities. To add insult to injury, plaintiffs’ lawyers are also bringing separate actions around the world to recover for losses suffered from securities purchased outside of the U.S. The result is vastly more expensive claim resolution due to multiple actions around the world, with many lawyers madly working in each jurisdiction, and a greater practical settlement value due to the “let’s just get this over with” dynamic—but with uncertainty about the ability to obtain a worldwide release. So insurers now face a world in which claims are more severe, and in which the anticipated decline in the number of claims has not materialized.

London insurers and brokers are grappling with how to bring some order to this chaos. I don’t see an easy fix. As long as U.S. courts can’t accommodate all claims, worldwide litigation can’t be “won”—it can only be managed and settled as efficiently as possible. This requires strong strategic control of the overall litigation, both to orchestrate settlements in the most efficient fashion and to avoid lawyers in every jurisdiction doing duplicative and unproductive legal work.

Critically, strong strategic control must be imposed by an independent lawyer—someone who would obviously be paid for his or her time, but who otherwise has no financial interest in the worldwide work. Independence would give the strategic lawyer freedom from law-firm economics when making decisions about which lawyers should be doing what—and which lawyers should be doing nothing—as well as about when to settle. In other words, if Dewey Cheatham & Howe is worldwide defense counsel, with multiple offices and dozens of lawyers working on the case, the strategic leader should not be a Dewey Cheatham & Howe lawyer.

But who would play such a role? Although many companies of course have excellent in-house lawyers, very few have in-house lawyers who formerly were prominent securities litigators. So should the strategic quarterback be a securities litigator from a firm other than the worldwide defense firm? Should it be the broker? Should it be a lawyer for the primary or a low excess carrier? These are all good possibilities. And how can this arrangement be put in place before the litigation defense is already beyond control? Having the discussion is an important first step, and London insurers and brokers are working hard to figure this out.

3. The danger of a wave of D&O claims relating to cyber security remains real.

One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue. Although many practitioners and D&O insurers and brokers have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle. Yet among D&O insurers and brokers in London and elsewhere, there remains a concern that a wave is coming.

I share that concern. To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches. That is bound to change as the market begins to distinguish companies on the basis of cyber security. There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security. Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.

I also worry about SEC enforcement actions concerning cyber security. The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk. But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area. All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security. And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously. As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.

In addition to an increase in frequency, I worry about severity because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure. Indeed, the shareholder litigation may well be ugly: The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.

Cyber security has improved, albeit not enough, in part because of the thought leadership and product development by insurers and brokers. So even if there is never a wave of D&O cyber security matters, the excellent work by insurers and brokers in London and around the world will have been worthwhile.

The Roots of D&O Insurance

London insurers and brokers are also focused on finding the right coverages for entities and individuals in the Yates-memo regulatory environment. This of course can create tension between entities, who would like their investigations costs covered, and individuals, for whom D&O insurance was created.

I am a D&O insurance fundamentalist—director and officer protection should always be our North Star. But a company can find the right path to protection of both individuals and the company with good communication between and among the company, its directors and officers, broker, and insurers—both at policy inception and when a claim arises.

It was a privilege to discuss this fundamental D&O insurance question, and many others, with thoughtful D&O insurance professionals who work just down the street from Edward Lloyd’s coffee house.

the stock options backdating cases, most of which were actually derivative cases, but many plaintiffs’ firms devoted class action resources to them;

the credit crisis cases; and

the Chinese reverse-merger cases.

In fact, the out-of-the-ordinary type of securities case has become ordinary; we have been in a series of waves for the past 20 years.

But we are not in one now, and I’m often asked, “What’s next?”

Although I don’t know if we’re about to enter a period of quirky cases, like stock options backdating, I’m confident that we’re going to experience a storm of non-M&A securities class actions caused by a convergence of factors: an increasing number of SEC whistleblower tips, a drumbeat for more aggressive securities regulation, a stock market poised for a drop, and an expanded group of plaintiffs’ firms that initiate securities class actions.

The SEC’s Whistleblower Program

The Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to give bounties to certain whistleblowers. With awards in the range of 10 percent to 30 percent of monetary sanctions over $1 million, the bounties were designed to attract meaningful tips.

The program caused a stir. Plaintiffs’ law firms established whistleblower practice groups and hired former SEC enforcement officials. The SEC created the Office of the Whistleblower, increased staffing, set up a website and hotline system, etc. Corporate firms published myriad client alerts and held hundreds of seminars—and braced for their own bounties, in the form of new work caused by more internal and SEC investigations, and resulting securities class actions. I told my family that I’d see them when I retired.

Yet it took a while for the whistleblower program to get rolling. The number and amount of the early awards were surprisingly low. But, as featured on the SEC’s website, they have increased steadily, and are now at significant levels. In total, the SEC has paid out more than $100 million in bounties. The number of tips has increased from 3,000 in the program’s first fiscal year to 4,000 last year. SEC Chair Mary Jo White calls the bounty program a “game changer” and Director of Enforcement Andrew Ceresney says it has had a “transformative impact on the agency.” Indeed, last year, the SEC filed 868 enforcement actions, a single-year high.

Calls for Increased Government Enforcement

Just as the bounty program is hitting its stride, the political environment again seems to be turning against corporations due to the perceived failure of the government’s securities enforcement efforts in the aftermath of the credit crisis and the recent Wells Fargo scandal, among other factors. And, of course, this election season has been marked by widespread anti-establishment sentiment.

During my nearly 25 years as a securities defense lawyer, I have seen the pendulum swing back and forth, from outrage against corporations, to outrage against the unfairness of SEC enforcement and the ethics of plaintiffs’ lawyers. Although I don’t think anti-corporate sentiment significantly changes the rate of government enforcement—they do the most they can with their resources, and are constrained by burdens of proof—I do strongly believe that anti-corporate sentiment increases the number and severity of private securities class actions.

We evaluate the state of the securities class action litigation environment primarily by reference to the rate at which cases are dismissed. Over the history of securities litigation, the biggest driver of the rate of dismissal is not any legal standard, but instead is the overall public attitude toward the value of private securities litigation. Whether facts are “particularized,” or an inference of scienter is “strong,” are subjective judgments that give judges wide latitude to dismiss a complaint, or not. Judges are people. They read the news. They talk to friends. They have children who are Millennials. They have seen people they thought were good do bad things. When public sentiment is anti-corporation, the judicial environment is inevitably influenced.

When the judicial environment changes, plaintiffs’ lawyers increase their investment in securities litigation—both in the number of cases they file, and how hard they litigate cases. Two waves of cases provide examples:

In the Chinese reverse merger cases, plaintiffs’ firms filed securities class actions against virtually every Chinese company about which there was a report of a problem. Plaintiffs defeated nearly every motion to dismiss, especially in the Central District of California. Although the economic recoveries in those cases weren’t substantial due to a lack of company and insurance resources, several smaller plaintiffs’ firms went all in.

In the stock option backdating cases, plaintiffs’ firms filed against nearly every company that had a potential backdating problem. Plaintiffs defeated motions to dismiss at a high rate, and settled cases for relatively large amounts. The backdating cases greatly raised the level of derivative settlements, established several smaller plaintiffs’ derivative firms as players in shareholder litigation, and were incredibly lucrative for larger plaintiffs’ firms.

Expansion of Plaintiffs’ Securities Class Action Firms

The stock-options backdating cases and the Chinese reverse merger cases have another thing in common: they have fueled an expansion of the plaintiffs’ bar.

The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, have retained a handful of prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount for cases that survive dismissal motions is fairly low.

These dynamics placed a premium on experience, efficiency, and scale. Larger firms thus filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

This started to change with the wave of cases against Chinese issuers in 2010. Smaller plaintiffs’ firms initiated the lion’s share of them, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements for amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

These outcomes built on gains smaller plaintiffs’ firms made during the stock options backdating cases, in which several smaller plaintiffs’ firms did quite well picking up matters in which the larger plaintiffs’ firms didn’t win the lead role, or working with the larger firms as co-counsel. Fueled by their economic and lead-plaintiff successes, these smaller firms have built up a head of steam that has kept them going, even after the wave of China cases subsided. For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases. Like the China cases, these cases tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs—for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

Although it isn’t possible for me to know for sure, I strongly believe that there is a very large amount of capacity among the larger and smaller plaintiffs’ firms to increase securities class action filings. Larger plaintiffs’ firms have only recently finished working through the bulge of the credit crisis cases, and employ a large number of securities class action specialists who have time for more cases. And the smaller firms are aggressively filing cases and pursuing lead-plaintiff roles.

One of my mentors used to say that “nature abhors a vacuum,” when predicting that there would always be a steady supply of securities litigation. In a twist on this maxim, I like to say that plaintiffs’ securities class action specialists aren’t going to become doctors or dentists—or even derivative litigation lawyers. Instead, this large group of lawyers will always file as many securities class actions as they can. And now, with smaller plaintiffs’ firms hitting their stride, the supply of plaintiffs’ securities class action lawyers is very large, and is looking for more work.

Is There a Securities-Litigation Storm on the Horizon?

I believe that the convergence of these factors, as well as the predicted drop in the stock market, will significantly increase the number of securities class actions. Indeed, the next big wave in securities litigation may well not be a type of case caused by a unique event, such as options backdating, but instead a perfect storm of cases caused by a competitive blitz by plaintiffs’ firms, as companies report bad earnings results as the economy and stock market decline, and as whistleblower bounties and other SEC enforcement tools unearth disclosure problems. And throw in other lawsuit-drivers, such as short-seller hit-pieces, and we could see an unprecedented storm of securities class actions.

The fifth of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to move securities class action damages expert reports and discovery ahead of fact discovery. This simple change would allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and allow the parties to make more informed litigation and settlement decisions.

Securities class actions are often labeled “bet the company” cases because they assert large theoretical damages and name the company’s senior management and sometimes the board as defendants. In reality, however, very few securities class actions pose a real threat to the company or its directors and officers. Most securities class actions follow a predictable course of litigation and resolution. Nearly all cases settle before trial. And, with the help of economists, experienced defense lawyers and D&O insurance professionals can predict with reasonable accuracy the settlement “value” of a case based on historical settlement information and their judgment.

Historically, settlement amounts were driven by an accurate understanding of the merits of the litigation and damages exposure. Cases that weren’t dismissed on a motion to dismiss were often defended through at least the filing of a summary judgment motion and the completion of damages discovery. This kind of vigorous defense is no longer economically rational in the lion’s share of cases, because of the high billing rates and profit-focused staffing of the typical defense firms—primarily firms with marquee names. Those firms’ skyrocketing defense costs threaten to exhaust most or all of the D&O insurance towers in cases that are not dismissed on a motion to dismiss. Rarely can such firms defend cases vigorously through fact and expert discovery and summary judgment anymore.

The reality of these economics is increasingly leading to mediations and settlements very early in the litigation, if a case isn’t dismissed. But, though rational, this comes at a high price. Early settlements are, by definition, less informed than later settlements. Plaintiffs’ lawyers must push for a higher settlement payment to compensate for the risk that they are settling a meritorious case for too little, and to increase the baseline for a smaller percentage fee due to a lower lodestar. Defendants and their insurers tend to be willing to overpay because they are saving on defense costs by not litigating further, and because there may be some downward pressure on the settlement amount since the plaintiffs’ lawyers will be doing less work too.

Damages considerations also loom large. At an early mediation, before damages expert discovery, the parties typically come to the mediation only with a preliminary damages estimate that neither side has thoroughly analyzed, much less tested through intensive work with the experts and expert discovery. Rigorous expert work often significantly reduces realistic damages exposure. For example, stock drops that lead to a securities class action are often the result of multiple negative news items. A rigorous damages analysis parses each item from the total stock drop to isolate the portion caused by the revelation of the allegedly hidden truth that made the challenged statements false or misleading. A defense firm that is motivated to settle the litigation sometimes does not want to do this work, so that it can use the large bet-the-company damages figure to pressure the insurer into settling for an amount that the plaintiffs will take. A defense lawyer might say, “Our economist says that damages are $1 billion, so the $30 million the plaintiffs are demanding is a reasonable settlement.” But expert analysis and discovery may well push the $1 billion number down to a much lower number, which in turn would dramatically reduce a reasonable settlement amount. Worsening this problem is the increasing unwillingness of mediators and plaintiffs’ lawyers to base settlement amounts on historical data—which places the preliminary damages analysis at the center of the negotiations.

This problem leads to my fifth wish: expert damages analysis and discovery should be the first thing we do after a motion to dismiss is denied. This will help us know if the case is really a big case, or is a small case that just seems big. Everyone would benefit. Plaintiffs and defendants would be able to reach a settlement more easily, based on true risk and reward. Insurers would know that they are funding a settlement that reflects the real risk, in terms of damages exposure. And courts would feel more comfortable that they are approving (or rejecting) settlements based on a litigated assessment of damages. Indeed, placing damages expert work first would help serve the core policy of our system of litigation: “to secure the just, speedy, and inexpensive determination of every action and proceeding.” Federal Rule of Civil Procedure 1.

Although the logic of my wish would lead to full fact discovery before mediation as well, so that settlements can be fully informed, I favor a continued stay of fact discovery during early expert discovery. Early expert discovery can be accomplished relatively quickly and efficiently, whereas fact discovery can be immediately and wildly expensive—which is primarily what drives very early settlements. And although plaintiffs and defendants often disagree about the relevance of fact discovery on damages, the absence of fact discovery for consideration in damages analysis is a factor the parties can weigh in evaluating the damages experts’ opinions. Unless and until the cost of discovery becomes more manageable, continuing the fact-discovery stay while expert damages discovery proceeds would strike the right balance.

Accelerating the timing of damages expert discovery would align it with the work required by damages experts to analyze price-impact issues under the Supreme Court’s 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (“Halliburton II“). In Halliburton II, the Supreme Court held that defendants may seek to rebut the fraud-on-the-market presumption of reliance, and thus defeat class certification, through evidence that the alleged false and misleading statements did not impact the market price of the stock. Unifying these two overlapping economic expert projects would create efficiencies for the lawyers and economists. Completing both of them before fact discovery starts would avoid unnecessary discovery costs if the Halliburton II opposition defeated or limited class certification, or if the damages analysis facilitated early settlement.

I’m sure it is not lost on readers that I just argued for a fundamental reform in the procedure for securities class action litigation to fix a problem that is primarily caused by the inability of typical defense firms to efficiently and effectively defend a securities class action even through summary judgment. To say the least, a system of litigation that can’t accommodate actual litigation is broken. Significant change in securities litigation defense is inevitable.

I hope that this series has provoked thought and discussion about ways to re-focus our system of securities litigation defense on its mission: to help directors and officers through litigation safely and efficiently, without losing their serenity or dignity, and without facing any real risk of paying any personal funds. Here, again, are my five wishes:

Make the Supreme Court’s Omnicare decision a primary tool in the defense of securities class actions. Obviously, Omnicare should be used to defend against challenges to all forms of opinions, including statements regarded as “puffery” and forward-looking statements protected by the Reform Act’s Safe Harbor for forward-looking statements. But defense counsel should also take advantage of the Supreme Court’s direction in Omnicare that courts evaluate challenged statements in their full factual context. Omnicare supplements the Court’s previous direction in Tellabs that courts evaluate scienter by considering not just the complaint’s allegations, but also documents incorporated by reference and documents subject to judicial notice. Together, Omnicare and Tellabs allow defense counsel to defend their clients’ honesty with a robust factual record at the motion to dismiss stage. (5 Wishes for Securities Litigation Defense: Effective Use of the Supreme Court’s Omnicare Decision)

Move damages expert reports and discovery ahead of fact discovery, to allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and to make more informed litigation and settlement decisions.

In combination with the Delaware Court of Chancery’s decision in In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016), Judge Posner’s blistering opinion In re Walgreen Company Stockholder Litigation, 2016 WL 4207962 (7th Cir. Aug. 10, 2016), may well close the door on disclosure-only settlements in shareholder challenges to mergers. That certainly feels just. And it may well go a long way toward discouraging meritless merger litigation. But, as I’ve cautioned, I am concerned that we will regret it. Lost in the cheering over Trulia and Walgreen is a simple and practical reality: the availability of disclosure-only settlements is in the interests of merging companies as much as it is in the interests of shareholder plaintiffs’ lawyers, because disclosure-only settlements are often the most timely and efficient way to resolve shareholder challenges to mergers, even legitimate ones.

I am offended by meritless merger litigation, and have long advocated reforms to fix the system that not only allows it, but encourages and incentivizes it. Certainly, strict scrutiny of disclosure-only settlements will reduce the number of merger claims—it already has. Let’s say shareholder challenges mergers are permanently reduced from 90% to 60% of transactions. That would be great. But how do we then resolve the cases that remain? Unfortunately, there aren’t efficient and generally agreeable alternatives to disclosure-only settlements to dispose of a merger lawsuit before the closing of the challenged transaction. Of course, the parties can increase the merger price, though that is a difficult proposition. The parties can also adjust other deal terms, but few merger partners want to alter the deal unless and until the alteration doesn’t actually matter, and settlements based on meaningless deal-structure changes won’t fare better with courts than meaningless disclosure-only settlements.

If the disclosure-only door to resolving merger cases is shut, then more cases will need to be litigated post-close. That will make settlement more expensive. Plaintiffs lawyers are not going to start to settle for less money, especially when they are forced to litigate for longer and invest more in their cases. And in contrast to adjustments to the merger transaction or disclosures, in which 100% of the cash goes to lawyers for the “benefit” they provided, settlements based on the payment of cash to the class of plaintiffs require a much larger sum to yield the same amount of money to the plaintiffs’ lawyers. For example, a $500,000 fee payment to plaintiffs’ under a disclosure-only settlement would require around $2 million in a settlement payment to the class to yield the same fee for the plaintiffs’ attorneys, assuming a 25% contingent-fee award.

The increase in the cash outlay required for companies and their insurers to deal with post-close merger litigation will actually be much higher than my example indicates. Plaintiffs’ lawyers will spend more time on each case, and demand a higher settlement amount to yield a higher plaintiffs’ fee. Defense costs will skyrocket. And discovery in post-close cases will inevitably unearth problems that the disclosure-only settlement landscape camouflaged, significantly increasing the severity of many cases. It is not hard to imagine that merger cases that could have settled for disclosures and a six-figure plaintiffs’ fee will often become an eight-figure mess. And, beyond these unfortunate economic consequences, the inability to resolve merger litigation quickly and efficiently will increase the burden upon directors and officers by requiring continued service to companies they have sold, as they are forced to produce documents, sit for depositions, and consult with their defense lawyers, while the merger case careens toward trial.

Again, it’s hard to disagree with the logic and sentiment of these decisions, and the result may very well be more just. But this justice will come with a high practical price tag.

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